Dear Messrs. Barnes, Bermingham, Dashe, Dunn, Higby and Levitt and Mmes. Black and Nicholas,
As an interested observer to the events unfolding around Herbalife (HLF) since December 20, 2012, the vigorous debate concerning Herbalife's business model, accounting, and disclosure practices (the "Key Issues") has been one for the record books. I have reviewed Mr. Ackman's presentation and a number of posts on Seeking Alpha and other web sites taking pro and con positions vis-a vis the Key Issues, although the volume of these posts is such that I'm not sure anyone could get their arms fully around all of the issues that have been raised or allegedly concluded. This article will address what I believe are the components of the Key Issues that Herbalife's forthcoming Form 10-K needs to address in order for Herbalife to resolve inconsistencies in disclosure and public statements, provide more transparency to investors in financial reporting, and presumably deter regulatory action.
It must be noted that even if Mr. Icahn's suggestion of a going private transaction is implemented, the Key Issues are of such criticality that any informed stockholder vote in a going private transaction would necessarily require disclosure addressing the Key Issues. In other words, taking Herbalife private will not obviate the need to address the Key Issues.
As the independent directors of Herbalife, you have collectively and correctly to date deferred to Mr. Johnson in providing Herbalife's public responses to charges by Mr. Ackman and others. However, from the perspective of your duties as independent directors and fiduciaries, the forthcoming 10-K will be "the" opportunity for you - as board members and, in some cases, members of the audit committee - to ensure that the questions surrounding the Key Issues are answered fully, transparently, and in a way which clarifies any prior inconsistencies in public statements or disclosures. I would suggest that if there was ever a time for independent directors to be fully engaged and to understand the intricacies of Herbalife's reporting and disclosure practices, this is it. Now is not the time to defer to management without inquiring and confirming for yourselves the facts. If you do not exercise extraordinary diligence at this point, later proceedings and class action suits will undoubtedly and prominently feature charges against you in your capacities as independent directors.
Before getting to the Key Issues, three related points must be addressed:
(1) To the extent that any prior Herbalife public statements or disclosures have contained inconsistencies, inaccuracies, or the potential to create investor confusion, there will be those who will advocate to you that Herbalife is best off if it does not address these issues. They will advise that Herbalife will open itself up to additional charges by Mr. Ackman and others, and may even invite class action suits based on disputed issues inherent in the prior statements or disclosures. I would strongly suggest you resist such entreaties. Yes, there may be exposure that comes with sunlight; however, further corporate obfuscation of questioned statements or disclosures will simply further the efforts by Mr. Ackman and others to cast additional doubt on Herbalife's handling of the Key Issues. Now is not the time to be cautious; rather, now is the time to be bold and to reduce, rather than enhance, the skepticism that pervades Herbalife's world. Transparency is not simply a guide here, but must be the overriding factor that drives Herbalife's disclosure practices. This is also, it so happens, your best protection from liability.
(2) I do not have any long or short position in any securities of Herbalife. I have no vested interest in seeing Herbalife's stock go up or down. I prepared this open letter to you in order to highlight the Key Issues that I believe must be addressed fully in the forthcoming 10-K, to stimulate discussion of your responsibilities, and remind you of your unique position to affect events that will likely determine Herbalife's future.
(3) Mr. Ackman's latest salvo includes pages and pages of questions. While many of these questions are substantive and deserve answers, I believe that you - as directors - will best serve Herbalife by narrowing your focus to the Key Issues. This will allow you to focus directly on what investors, regulators, and others need (and want) to understand about the most important elements of Herbalife's operations, business model, financial reporting, and disclosures. I invite others to add to the following list, although those doing so should bear in mind that brevity is the soul of wit.
Now to the Key Issues:
1. Please fully analyze and differentiate retail sales from sales to distributors. This should include a reconciliation or correction of prior inconsistent disclosures or public statements by senior management. Address in particular the estimate of 5 million retail customers, the mechanism used to arrive at the estimate, and assumptions underlying the estimate.
2. Please fully analyze the retail pricing of Herbalife products versus competitive products sold at retail. If Herbalife's prices are significantly above comparable products sold by competitors, disclose how Herbalife addresses pricing discrepancies with its distributors and retail customers. This disclosure should analyze fully the other factors on which Herbalife competes in its five product categories.
3. Disclose in greater detail all surcharges, shipping and handling, and miscellaneous expenses that are billed to distributors. Review relevant practices of distributors to facilitate disclosure of whether retail product prices charged by distributors are net of these charges or the charges are passed along to retail customers. If the charges are passed on to retail customers, describe the impact on retail product prices paid by retail consumers.
4. Please review statements on Herbalife's web site and in its marketing materials and provide a reconciliation of significant discrepancies between those statements and reports filed with the SEC. This reconciliation should include an analysis of research and development expenditures, among others.
5. Please review and fully analyze whether revenue should be reported net of distributor allowances, rather than gross. Consider whether distributor allowances should be reclassified to SG&A. Because retail sales have not been verified, consider eliminating product sales as the "topline" in the income statement. Evaluate whether Herbalife's distributor allowances should be restated as distributor allowances and wholesale commissions, and whether these allowances and commissions should be reclassified as an operating expense. Your financial statement footnotes should provide a breakdown of variable and fixed distributor facing expenses. Disclose whether the audit committee discussed any or all of the foregoing issues with KPMG LLP and whether KPMG recommended to management or the audit committee any revisions to the financial statement presentation. If so, disclose whether the audit committee followed this recommendation and, if not, why not.
6. Disclose fully when distributors are counted as retail customers, and how many product sales are for internal consumption. If you cannot access this information, provide the company's best estimate of internal consumption and describe the factors considered in arriving at this estimate. Include how the board weighted the factors that underlie the estimate.
7. Disclose inactive sales leaders and non-sales leaders for each of the last three years for each region and country for which active sales leader information is disclosed. Disclose new sales leaders and new distributors by country for any country which accounts for more than 5% of net sales in the relevant period.
8. Inconsistencies appear to exist in how geographic regions have in the past been defined and, as a result, it is not clear if period-to-period information has been presented in all cases. Confirm that comparisons to prior years' regional results were restated to take into account changes in the definition of geographic regions.
9. Analyze and disclose the effect on net sales of entering new countries in each region, breaking down net sales in each region by (A) net sales within existing countries, and (B) net sales within countries entered within the last 12 months. A separate table should be provided for net sales in each region for countries in which Herbalife has sold products for more than three (3) years, and for countries in which products have been sold for less than three (3) years. These tables should include percentage increases and decreases to facilitate investor understanding of the effect of entering new countries on net sales, and sales trends within "established" countries.
10. Your disclosure does not appear to address what regulatory mandates apply to Nutrition Clubs, the extent to which Herbalife has dictated operating strictures of Nutrition Clubs, and the primary risk exposures that distributors may encounter in operating Nutrition Clubs. (See, for example, pages 18-24 of 2012 Form 10-K.) Given the degree of contractual control Herbalife maintains over Nutrition Clubs, disclose the effect of a finding that Herbalife is a responsible party for activities conducted at Nutrition Clubs. Also, disclose if and how Herbalife informs its distributors of risks associated with operation of Nutrition Clubs, e.g., food safety and other regulatory or licensing issues.
In summary, you as directors should remember the old maxim: disclosure cures all. If the board cannot subscribe to this, you need to reevaluate the board's commitment to risk management - before it is too late.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.